Interest Coverage (IC) Tests
Definition
A covenant in CLOs and other structured credit products that measures whether the interest income generated by the collateral pool is sufficient to pay interest on the debt tranches. IC tests protect debt holders by triggering cash flow diversion if interest coverage deteriorates below required thresholds.
Why it matters
IC tests are the second critical protection mechanism for CLO tranches (alongside OC tests). While OC tests measure collateral value, IC tests measure cash flow. A CLO can have strong OC ratios but fail IC tests if the portfolio shifts to lower-yielding assets. When IC tests fail, interest proceeds that would flow to subordinated tranches are diverted to senior debt, ensuring timely debt service even as portfolio yield declines.
Common misconceptions
- •IC tests and OC tests measure different things. IC measures income vs. interest due; OC measures collateral value vs. debt principal. Both must pass for equity to receive distributions.
- •IC test failures don't mean missed payments to debt holders. They trigger cash flow diversion that prevents missed payments. Senior tranches continue receiving scheduled interest; subordinated tranches may see deferrals.
- •IC tests are more sensitive to spread compression than OC tests. If a manager trades BB loans (L+500) for BBB loans (L+300) to improve OC, IC ratios may deteriorate even as credit quality improves.
- •LIBOR/SOFR floors matter for IC tests. When rates fall below asset floors but liabilities keep repricing down, IC ratios can improve mechanically without any portfolio action.
Technical details
Calculation methodology
IC ratio = (interest income from collateral pool) ÷ (interest due on debt tranche). Interest income includes coupon payments from loans and bonds, typically calculated on a forward-looking basis using current spreads and reference rates. Most structures use a coverage period (often 12 months forward) rather than trailing income. The calculation excludes defaulted interest and may apply haircuts to interest on assets beyond certain rating or maturity thresholds. Exact methodology is indenture-specific.
Typical thresholds by tranche
AAA tranches typically require 120-130% IC (e.g., $120-130 of annual interest income for every $100 of AAA interest due). AA tranches require 110-115%. A tranches 105-110%. BBB tranches 102-105%. Lower-rated tranches have progressively lower requirements. These thresholds are generally tighter than OC thresholds because interest income is more volatile than principal values. Exact triggers are deal-specific; verify in the trustee report or indenture.
Cash flow diversion mechanics
When an IC test fails, cash flows that would otherwise be available for subordinated interest payments or equity distributions are redirected to pay down the senior tranche's principal balance (in many structures) or are trapped in reserve accounts. The specific diversion mechanics (interest proceeds vs. principal proceeds, which tranches are impacted) vary by deal and are indenture-specific. Unlike OC test failures that redirect principal proceeds, IC failures often redirect interest proceeds first, then principal if needed. Some structures allow managers to cure IC failures by trading into higher-yielding assets rather than deleveraging.
Why IC can fail while OC passes
IC tests measure yield, not credit quality. Example: Manager improves portfolio credit quality by trading L+500 BB loans for L+300 BBB loans. OC ratio improves (better ratings = full par value vs. potential haircuts). IC ratio deteriorates (300bps less spread income). This creates a tension: credit upgrades can hurt IC coverage. Also, during spread compression markets (2017-2018, 2020-2021), CLOs refinanced debt at tighter spreads but assets couldn't be traded without losses, creating IC pressure. Rate floors also matter—when LIBOR/SOFR fell below asset floors (2020-2021), liabilities repriced down but assets stayed at floors, improving IC mechanically.
IC vs OC: which fails first
Typically, OC tests fail before IC tests in credit deterioration scenarios (loans default → lose par value → OC fails, but remaining loans keep paying interest → IC holds longer). However, IC tests can fail first in yield compression scenarios (spread tightening, refinancing debt at lower spreads, or trading up in credit quality). In March 2020, most CLOs maintained both OC and IC compliance despite AAA tranches trading at 80 cents because: (1) performing loans still counted at par (OC), and (2) current-pay loans still generated interest income (IC). Defaults and downgrades eventually impact both tests, but OC reflects them faster since defaults immediately haircut collateral value.
Floating rate mechanics and IC tests
Most CLO assets and liabilities float with LIBOR/SOFR, but small mismatches create IC volatility. Assets often have floors (L+500 with 1% floor), while liabilities may not (or have lower floors). Rising rates: Both sides reprice up, but if asset floors were binding, IC improves as liabilities rise faster than assets. Falling rates: If asset floors bind, assets stop repricing down while liabilities continue falling, improving IC. During 2020-2021 zero rate environment, many CLOs saw IC improvement purely from floor mechanics, not portfolio changes. This is why IC analysis requires understanding floor structures and rate environments.